Most investment institutions have boards of trustees or the like. The trustees are entrusted with investment funds and have a fiduciary duty to the beneficiaries of the funds. The trustees almost always delegate the day-to-day management of the investment funds to a third party investment manager because the trustees are often not sufficiently skilled in such management. The trustees normally require the investment manager to enter into a mandate associated with an investment management agreement. The mandate describes the objectives set for the investment manager and recites the investment manager's powers and duties. The mandate greatly influences the manner in which the investment manager operates because the mandate usually prescribes in detail the target(s) that the investment manager is expected to achieve, the constraints under which he must operate and any applicable performance measurement methods.
Before the identification and commissioning of an investment manager, the trustees usually decide in which asset classes to invest the funds and in what proportions. In the conventional framework, asset allocation decisions are regarded as of over-riding importance and are commonly addressed by means of mathematical or statistical simulations, for example, using asset-liability studies. Asset allocation decisions and strategies are complicated and quite technical and, thus, many trustees appoint an investment adviser to handle such decisions and strategies. The investment advisor may also be responsible for selecting investment manager(s) and in drafting the mandate(s) for the trustees. Given the imbalance of expertise between the trustees and the investment adviser, it is not surprising that, in practice, the investment advisor makes most of the critical decisions in the name of the trustees.
There is little competition amongst investment advisors because if trustees replace one advisory firm for another advisory firm, it is highly unlikely that the replacement advisory firm will give any significantly different advice. Such consensual behavior by the advisor community has natural business advantages to the community as a group. The business advantages include enabling the advisor community to dominate the institutional investment process despite the fact that that as individuals they rarely have experience in actually managing investments.
The conventional arrangements for the investment of funds rely heavily on the notion that stock markets are “efficient”, that is, stock market prices are set in a manner that prevents any systematic achievement of an above average rate of return, net of the costs involved, except by accepting a higher level of risk or degree of volatility of the outcome. By contrast, the exemplary embodiments described in the present application are predicated on the belief that stock markets are not efficient. In particular, there are opportunities for arbitrage, that is, entering into a transaction that can later be reversed at a profit, provided an adequate time period is available to the investment manager. In the conventional arrangements, such opportunities are prevented by the short-term nature of the investment performance measurement system. Indeed, this short-term approach is a contributory cause of the anomalies which give rise to the favorable arbitrage opportunities described above.
Investment performance is traditionally measured by income received and change in market value during a measurement period. In practice, such measurements are made very frequently, for instance, on a monthly basis, or on a quarterly basis at the longest. The investment manager focuses on the market value of the portfolio—the collective term for the investment holdings selected—and how the market is expected to move over the short-term. If the investment manager takes a longer-term view, the investment manager incurs a serious business risk due to the volatility of the market. Hence, in practice, the investment manager devotes a large part of its efforts to trying to second guess the market, leading to excessive buying and selling of holdings so as to gain an advantage, albeit a small one, over whatever index portfolio represents the investment performance target set in the mandate.
Therefore, in a conventional mandate, an investment manager is typically instructed to outperform a market index, for example, to outperform the S&P 500 by 1% p.a. over rolling three year periods subject to quarterly monitoring, maximum permitted underperformance over a given period say, four quarters, tracking error or active risk of a particular percentage such as 3%, and specified active money statistics at the sector and individual stock levels. The effect of such a mandate is to induce investment managers to be closest-indexers, that is, to base their investment decisions on the index weights of individual securities rather than their intrinsic merits. Hence, investment managers are forced under a conventional mandate to try to anticipate changes in market sentiment, that is, to try to guess which stocks will benefit from short-term changes in market value through movements in market sentiment (referred to herein in as the “revaluation effect”).
Accordingly, a need exists for a new approach to setting investment mandates and inducing change in investment manager behavior with a de-emphasis on market performance. There is also a need, however, for achieving goals associated with market performance without expressly seeking to outperform the market. The exemplary embodiments of the present application described herein are based on the principle that an investment manager is given control over a series of cash flows and exercises his discretion to improve the terms on which he purchases future cash flows. Therefore, the investment manager takes advantage of the re-rating of securities by the market.